Both CAPM and APT consider only one time period and treat the
risk-free interest rate as an exogenous parameter. However, in real
life, investors make investing and consumption decisions that are in
effect for long periods of time. An interesting direction in the port-
folio theory (that is beyond the scope of this book) describes invest-
ment and consumption processes within a single framework. The risk-
free interest rate is then determined by the consumption growth and
by investor risk aversion. The most prominent theories in this direc-
tion are the intertemporal CAPM (ICAPM) and the consumption
CAPM (CCAPM) [2, 3, 7].
The simple investment strategy means ‘‘buy and hold’’ securities
of ‘‘good’’ companies until their performance worsens, then sell them
and buy better assets. A more sophisticated approach is sensitive to
changing economic environment and an investor’s risk tolerance,
which implies periodic rebalancing of the investor portfolio between
cash, fixed income, and equities. Proponents of the conservative
investment strategy believe that this is everything an investor should
do while investing for the ‘‘long run.’’ Yet, many investors are not
satisfied with the long-term expectations: they want to make money
at all times (and who could blame them?). Several concepts being
intensively explored by a number of financial institutions, particu-
larly by the hedge funds, are called market-neutral strategies.
In a nutshell, market-neutral strategy implies hedging the risk of
financial losses by combining long and short positions in the port-
folio. For example, consider two companies within the same industry,
A and B, one of which (A) yields consistently higher returns. The
strategy named pair trading involves simultaneously buying shares
A and short selling shares B. Obviously, if the entire sector rises,
this strategy does not bring as much money as simply buying
shares A. However, if the entire market falls, presumably shares B
will have higher losses than shares A. Then the profits from short
selling shares B would more than compensate for the losses from
buying shares A.
118 Portfolio Management
Specifics of the hedging strategies are not widely advertised for
obvious reasons: the more investors target the same market ineffi-
ciency, the faster it is wiped out. Several directions in the market-
neutral investing are described in the literature [8].
Convertible arbitrage. Convertible bonds are bonds that can be
converted into shares of the same company. Convertible bonds
often decline less in a falling market than shares of the same company
do. Hence, the idea of the convertible arbitrage is buying convertible
bonds and short selling the underlying stocks.
Fixed-income arbitrage. This strategy implies taking long and short
positions in different fixed-income securities. By watching the correl-
ations between different securities, one can buy those securities
that seem to become underpriced and sell short those that look
Mortgage-backed securities (MBS) arbitrage. MBS is actually a
form of fixed income with a prepayment option. Yet, there are so
many different MBS that this makes them a separate business.
Merger arbitrage. This form of arbitrage involves buying shares of a
company that is being bought and short selling the shares of the buying
company. The rationale behind this strategy is that companies are
usually acquired at a premium, which sends down the stock prices of
acquiring companies.
Equity hedge. This strategy is not exactly the market-neutral one, as
the ratio between long and short equity positions may vary depending
on the market conditions. Sometimes one of the positions is the stock
index future while the other positions are the stocks that constitute
this index (so-called index arbitrage). Pair trading also fits this
Equity market-neutral strategy and statistical arbitrage. Nicholas
discerns these two strategies by the level of constraints (availability of
resources) imposed upon the portfolio manager [8]. The common
feature of these strategies is that (in contrast to the equity hedge),
they require complete offsetting of the long positions by the short
positions. Statistical arbitrage implies fewer constraints in the devel-
opment of quantitative models and hence a lower amount of the
portfolio manager’s discretion in constructing a portfolio.
Relative value arbitrage. This is a synthetic approach that may
embrace several hedging strategies and different securities including
Portfolio Management 119

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